How the Options Tail Has Come to Wag the Market Dog: A Simple English Language Explanation of How Structural Changes in the Stock Markets Contribute to Whipsaw Movements in Prices

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Yves here. Please thank Eugene Linden for taking the effort to distill his considerable market experience into a clear and plausible interview of what has gone awry in our financial markets and why it’s entirely rational to be leery. The short version is options are increasingly driving prices.

Options are potentially hazardous because they are only as good as the counterparty “writing” the risk. We saw recently with the blowup of Archegos that the “family office” (a glorified name for a rich guy and some hangers-on but not enough investors so that the investment manager has to register as an investment adviser) had achieved tremendous levels of market exposure by using total return swaps rather than stock purchases, and these were further levered by borrowing against the cash hoard.

Typically the parties on the other sides of trades like this are hedge funds, so there isn’t necessarily a lot of systemic risk. But here, Credit Suisse and Nomura Holdings took big hits, but not enough to mortally wound them. And even then, if a hedge fund gets in trouble because it can’t make good on options bets it wrote, it could still kick off an unwind of borrowings from banks. Remember LTCM had borrowed from many banks, and when a massive bet in comparatively simple interest rate swaps went sour, the Fed had to get them into a room to agree on a bailout and wind-down.

But Eugene’s discussion reminds me of an older crisis, the 1987 market crash. A significant number of institutional investors had signed up for portfolio insurance, which was supposed to limit their exposure to market swoons. Instead, their herding into one trade did the reverse. Program trading generated automated selling in futures when stock market indices dropped below a certain level. The problem was a wave of automated sales then pulled stock market prices down, by arbitrage, that led to more automated selling of futures.

Even though the trading strategies now are allegedly more complicated, because algos, the model-makers use similar approaches to risk, which means the odds of herding and crowded trades are high.

By Eugene Linden, a chief investment strategist for a family of hedge funds specializing in distress and bankruptcies. He has also written several non-fiction books on science, technology, the environment, and articles and essays in Time, Foreign Affairs, The Wall Street Journal, and other major publications

Lately a string of violent price movements and reversals in the equity markets make it look like the markets are having a nervous breakdown. The last day of trading in April 2022 saw a 939 point drop in the Dow. The day before that, the Dow rose about 625 points, and two days before that it fell over 800 points. The very next week, after two quiet days, the Dow rose over 900 points after the Fed announced its biggest rate hike in 22 years (ordinarily a big negative for the markets), and then, the next day, fell over 1000 points (more on this later).  There have been plenty of headlines – about the Ukraine Invasion, inflation, the threat of a Fed caused recession, supply chain disruptions – to justify increased uncertainty, but the amplitude of the moves (and the sudden reversals) suggest something more may be at work. Here follows an effort to explain in simple language the significant changes in the market that have contributed to this volatility.

“This time it’s different” is perhaps the most dangerous phrase in finance as usually it’s uttered by market cheerleaders just before a bubble bursts. That said, markets do change, and those changes have their impacts. One change in the markets has been the shift from intermediaries (such as brokers) to direct electronic trading, a shift that has made the markets somewhat frictionless, and allowed computer driven funds to do high speed trading. This shift began a couple of decades ago. Today’s markets can move faster than a human can react.

Another shift has been the degree to which passive investing through index funds and algorithmic trading through various quant funds have come to eclipse retail investing and dominate trading. A consequence of this is that to some degree it has mooted individual stock picking because when investors move in or out of index funds, the managers have to buy or sell the stocks held on a pro rata basis and not on individual merit. This change too has been developing over recent decades.

A more recent and consequential shift, however, has been the explosion in the sale of derivatives, particularly options (the right to buy or sell a stock or index at a specified price on or before a specific date). Between 2019 and the end of 2021, the volume of call options (the right to buy a stock at a specified price on or before a particular date) has roughly doubled. During times of volatility, more and more retail and institutional investors now buy calls or puts rather than the stocks.

Today, trading in options has reached a scale that it affects market moves. A critical factor is the role of the dealers who write options and account for a significant percentage of the options issued. Dealers have been happy to accommodate the growth in option trading by selling calls or puts. This however, makes them essentially short what they have just sold. Normally, this doesn’t matter as most options expire out of the money and worthless, leaving the happy dealer to book the premium. Being short options, however, does begin to matter more and more as an option both moves closer to being in the money and closer to expiration.

This situation is more likely to occur when markets make large and fast moves, situations such as we have today given the pile of major uncertainties. Such moves force dealers to hedge their exposure.

Here’s how it works. If, for instance, a dealer has sold puts on an index or a stock, as a put comes closer to being in the money (and closer to expiration), the dealer will hedge his short (writing the put) by selling the underlying stock. This has the combined effect of protecting the dealer — he’s hedged his potential losses – while accelerating the downward pressure on the price. In other words, this hedging is pro-cyclical, meaning that the hedging will accelerate a price move in a particular direction.

Traders look at crucial second derivatives of stock prices, referred to by the Greek letters delta and gamma to determine exposure to such squeezes. As an option moves closer to in the money it’s delta — it’s price movement relative to the price movement of the underlying, and its gamma — the rate of change of the delta relative to a one point move in the underlying, both rise. The closer to both the strike price and expiration date, the more the dealer is forced to hedge. The result is what’s called a gamma squeeze. Once the overhang of gamma exposure has been cleared, however, the selling or buying pressure abates, and gamma may flip, with new positioning and hedging done in the opposite direction. The result can be a whipsaw in the larger markets. This same phenomenon can happen with indexes and futures.

How do we know that the hedging of option positioning are contributing to violent price changes and reversals in the market? While not conclusive, perhaps the strongest evidence is that large lopsided agglomerations of options at or near the money have been coincident with surprising market moves as expiration dates approach. In fact, some market players use this data to reposition investments, in effect shifting investment strategy from individual companies to the technical structure of the markets. This is what Warren Buffett was referring to when, at his recent annual meeting, he decried the explosion of options and other Wall Street fads as reducing companies to “poker chips” in a casino.

The week of the May Fed meeting gave us a real-time example of how a market move that looks insane on the surface reflects the underlying positioning in various derivatives. To set the stage: ordinarily, given debt burdens and the threat of recession, the markets would be expected to react badly to a Fed tightening cycle that is accelerated by the biggest rate hike in 22 years. On Wednesday, however, market indices began to soar on Wednesday when Fed Chairman Powell, one half hour after the Fed announced it 50 basis point raise, suggested that the Fed was not considering larger 75 basis point hikes during this tightening cycle. Traders interpreted this as taking the most hawkish scenario off the table. Up to that point, institutions were extremely bearish in their positioning, heavily weighted to puts on indexes and stocks, and also positioned for future rises in volatility in the markets. Right after Powell made his comments, investors started hedging and unwinding this positioning, and all the pro-cyclical elements entailed in this repositioning kicked in. By the end of the day, the technical pressures producing the squeeze had largely abated, setting the stage for a renewed, procyclical push downward the next day, as the negative aspects of the tightening cycle (and other economic headwinds) came to the fore.

What these violent moves in the market are telling us is that while in the broader sense, this time is not different –the overall sine wave of the market is still that bubbles build and burst — how the present bubble is bursting may be following a different dynamic than previous episodes. The changes since the great financial crisis– the rise to dominance of passive trading through indexes and algorithmic trading through various quant strategies – reduced the friction in the markets as well as the value of picking individual companies. Now, the more recent explosion of option issuance, further accelerates market moves, and leads to unpredictable reversals that have to do with option positioning rather than fundamentals such as earnings, politics, or the state of the economy.

The tail (the options and other derivatives markets) now wags the dog (the equities markets).

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  1. Mikel

    I can believe this. I’ve seen the websites and such where people talk openly about their trades. They are getting inversed.

    And it wouldn’t be too out of pocket to tell people their pathway to a better retirement will resume once
    1) newbie option traders have been thoroughly fleeced, and there are more of them now than ever
    2) worker participation numbers improve (think of the establishment’s laser focus on worker wages, above all else, as the thing that is inflationary)

    1. lyman alpha blob

      Definitely believe it. It’s what pushed Gamestop’s stock to dizzying heights last year. A lot of the upward momentum was due to the gamma squeeze, not just “HODLERS”. ie people who buy and hold the stock even as it rises.

      1. Mikel

        I think there is an element of some bigwigs still punishing that group and associated ones.
        Every meme they bought is going to stay down in the dirt for as long as possible.

  2. Louis Fyne

    another factor is that individuals and institutions own a lot less individual stocks, replaced by ETFs. Creating less liquidity in shares (in a backdrop of stock liquidity moving to stock options)

    if/when a company releases unexpected news (Netflix, Walmart, Target, etc. earning misses) the stock “gaps” bigly as there is not enough liquidity.

  3. KD

    On the other hand, the effect of increased volatility due to gamma hedging by market makers and “dumb” indexing means that market pricing is less efficient on individual shares, and so more opportunity to purchase good businesses at cheap prices during a dip, and with a long-term horizon and no leverage, you may be able to make good long-term returns relative to indexed securities. . . assuming the neocons don’t start WWIII.

    1. eugene

      ETF’s also create market inefficiency. If significant money moves in or out of an ETF, they buy or sell the constituents pro rata from or to a Goldman or some such. That means that the wheat is sold with the chaff, mooting individual analysis of the stocks.

  4. Susan the other

    This is about as clear as mud. Why do options offset risk? I make a deal to buy/sell at some future point if it looks like I can make a small profit – because that’s better than taking an investment plunge into full-on risk of losing everything. And the same theory applies to index investing – to invest in the probabilities of overall risk and profit of the entire economy. Like mutual insurance. So hedging is the only choice for cautious investors these days. I don’t think this is “reducing companies to poker chips in a casino” at all. Just the opposite. It’s a natural tendency toward insurance against volatility. So it is curious why options traders “cause” so much volatility. You’d think they would smooth it all out so that before long there was minimal risk everywhere – offset by the fact that there was also minimal profit. So, far less volatility. So maybe “volatility” is the process of the cautious market balancing itself. Unless electronic trading is programmed to be foolish. Which would only be very funny if you were not invested the market. Electronic trading merely tries to get there first. So it is actually creating stability. or stg. Never mind.

    1. praxis

      A significant amount of short date to expirary and out of the money option purchases are just directional gambling. When liquidity dries up (passive indexing, fear etc), the massive derivative bets push the price around (counter party hedging / dealers that are short the options). Price ‘discovery’ becomes non linear.

      1. Susan the other

        Sounds like the AI computer that goes back and erases its own logic. When I read that I thought, well yes, that is the most intelligent thing to do when you are self-editing. You delete your big contradictions to make it all work. In the case of an AI computer deleting its own program, the question rises – Why isn’t it programmed to resolve the contradictions? And I’m drawing a far-fetched comparison here: Why don’t we take the time to resolve the confusion brought on by limited time constraints (isn’t that arbitrary anyway) to close deals? If everything went into a big escrow cloud until the quickest clickers and the slowest clickers could resolve their exact interests wouldn’t we have the smoothest, almost dead, markets imaginable?

    2. Mikel

      The higher a security goes, the cheaper the puts. The lower it goes, the cheaper the calls.

      You’re talking about how options were set up to be used. The author is talking about how, well, how they are being abused.

      They are being treated like lottery tickets.

    3. KD

      Options don’t lower volatility, they re-distribute it. This is the danger, because you have a bunch of people trying to pick up nickels in front of a steam roller at x4 or x5 leverage (or higher). Stock markets aren’t Gaussian, they have fat tails and people are terrible at estimating tail risk. I don’t know why there isn’t more discussion of futures, because you can get even crazier leverage in futures contracts.

    4. lyman alpha blob

      Options don’t necessarily have to cause volatility, but if certain trading strategies don’t go the right way for enough “investors”, Mr. Market gets stuck in a feedback loop where people trying to hedge against bad bets wind up driving a stock rapidly in one direction or the other.

      There was an incredibly good article posted here around the time of the Gamestop short squeeze last year that explained everything in detail. IIRC it involved “delta hedging” – couldn’t find the better article I was thinking of, but this explains it OK:

      1. KD

        Options do increase volatility. Market Makers need to remain delta neutral so they don’t blow up due to market extremes. So if speculators buy calls in TSLA, market maker is short delta in TSLA. Market maker needs to buy shares of TSLA to zero delta, which dries up liquidity, and drives up the price. This gets more speculators buying calls, and more delta hedging, in a speculative bubble. Same on the way down, if speculators buy puts, the market maker sells puts and is long delta and has to short to protect against price swings, and this causes greater price fluctuations down. The more options, the bigger the orders the market makers have to make to stay delta neutral, the less liquidity, the more price swings.

  5. amused_in_sf

    One things that is rarely remarked upon is how recent an invention the options market in individual stocks is. In the late 90s I had a friend who was making money on trading the newly available options for either Ford or GM, and I was astonished that they had not existed before then. So now we have options in much smaller, much more thinly traded companies.

    So this whole market has emerged in an environment of incredibly lax regulatory environment. I’m sure it will not end in disaster!

  6. Mo.B

    The nice young man who walks my dog lost all his hard earned savings in crypto. I tried telling him beforehand that he stood no chance, but why would he take my word for it? He finally understands that there are big whales moving the market, but I fear that he is still addicted. I think you can open a crypto account with $50 these days. Why isn’t that alone a warning sign?

    1. Mikel

      I’m trying to warn one of my brothers. It’s hard. I think I finally put something on his mind at least with the article about India’s warning about crypto.

  7. David in Santa Cruz

    Thank you for sharing Linden’s clear and concise explanation of the way American public equity markets are no longer based on, “…fundamentals such as earnings, politics, or the state of the economy.” Investors appear to be wagering on market movements caused by their own bets.

    This is probably less down to investment mechanisms than it is due to the lack of productive investment opportunities in the U.S. caused by corporate consolidation and globalization. We are living in a Potemkin Economy. The “shock” will come when investors come to the sanctions-based realization that Russia and China have economies based on actual commodities and actual industrial production. I’d rather own the steak than the sizzle.

  8. Glen

    Do we really need to call this mess a market? How about calling it what it is – the trough were the Federal Reserve dumps trillions for the Wall St pigs.

    It became detached from reality quite a while ago.

  9. flora

    Thanks very much for this post. I come to NC primarily for finance education.

    I remember the 1987 market crash and the emergency circuit breaker; I remember Long Term Capital Management’s “can’t fail” implosion; I remember the Asian Tigers’ suddenly finding reasons to change strategy, I remember the Fed’s so-called ‘plunge protection team’ and the rest of what you mention in the intro. “This time it’s different” – because some new theory – never seems to be different in reality. (Having PhDs and Nobel memorial Economics Prize winners consulting and guiding LTCM’s investment didn’t make “this time” any “different” for them. )

    I appreciate Mr. Linden’s post. It’s more education.

  10. Alan Roxdale

    Remember the single largest structural change of the all: Too Big to Fail.

    Banks and even hedge funds are making riskier and riskier bets in the certain knowledge that the Fed will make good their losses — so long as they are large enough to threaten the whole system.

  11. Boshko

    This post nicely captures the fact that the value of bets placed in markets generally outweighs the actual product traded by 10-to-1. Take oil futures, for example, a classic derivatives market that actually used to serve a purpose for producers of commodities or manufacturers with said commodities as a primary input. It made a lot of financial sense to bake-in existing prices for future production or sales under lots of market uncertainty.

    However, when options and derivatives become the product, not a means of hedging risk from exposure to the underlying product (e.g. an equity or commodity), then we end up with the financialized economy we see. Of course it becomes further unhinged when the buy/sell decisions are programmed and executed by an algorithm to execute at the speed of light and the distortions snowball quickly.

    What else should we expect when the bets outnumber the actual items to exchange by such a large margin? Traders love to point out that the notional or gross amounts traded aren’t meaningful and what’s really material is the net amount. But the gross amounts are what help cause the enormous swings to begin with. And rarely are realized losses anything resembling net exposures. It’s always closer to the gross amount.

    Just keep in mind the total notional amount of the interest rate derivatives market (about 75% of the derivatives market overall) is $475T. TRILLION. It’s a sum whose scale doesn’t even register it’s so large. Global GDP, things actually made, is ~$85T.

  12. LilD

    I’ve traded $ billions of options over my career

    Options are insurance policies.
    On average, selling insurance is profitable.
    Sometimes it’s not. Lots of small uncorrelated sales wins
    Correlation is hard to guess correctly

    Directional bets can be made in derivatives rather than in the underlying asset and payoffs are potentially highly leveraged

    Financial options have ( or used to have…) systematic mispricings which is my business… sources of which are interesting and beyond the scope of this note…. Now and then pure arbitrages show up but it’s rare

    In the absence of those however the market is pretty efficient and dealers make money. Counterparty risk is minimal for listed derivatives but silly for a lot of other things. It will end in tears 😭

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